How would a bond-financed fiscal expansion affect the exchange rate in a floating rate regime? The answer seems obvious in the Mundell-Fleming model, which is the standard model used in textbooks. With high international capital mobility there must be an appreciation, unless the money supply is expanded sufficiently. On the other hand, with low capital mobility, depreciation will result. Then there is the portfolio balance model which gives an ambiguous answer. In addition we have the various models that focus on the relationship between the real exchange rate and the current account, the models with an intertemporal budget constraint, the ‘unpleasant monetarist arithmetic’ model, and finally, models which focus on expectations and their determination. Indeed, one’s reaction might be that exchange rates in a floating rate regime depend primarily on expectations, and these are impossible to predict and hard to explain rationally after the event.
There is no shortage of models in these fields, and one can get confused—as I have been—as to how these models relate to each other. Hence, I have tried to sort this out. Formal mathematical expositions of the separate models can be found elsewhere. Here the aim is, above all, to present an integrated story in an intuitively convincing way.
The chapter is not empirical. There are, of course, examples of fiscal expansions and contractions with floating rate regimes, the most famous being the US fiscal expansion of the early 1980s. But the episodes do not give simple answers, possibly because of the variety of simultaneous monetary policies. Sometimes the exchange rate appreciated and sometimes it depreciated—and in the famous case of the United States, it appreciated for over four years and then sharply depreciated. 1 So here I stick to models.
It is a pleasure to contribute this paper in honor of Vito Tanzi, an